Posts Tagged ‘European Central Bank’

by Janet Daley via the Ludwig von Mises Institute of Canada (originally posted on The Telegraph)
November 27, 2012

Forget about that dead parrot of a question – should we join the eurozone? The eurozone has officially joined us in a newly emerging international organisation: we are all now members of the Permanent No-growth Club. And the United States has just re-elected a president who seems determined to sign up too. No government in what used to be called “the free world” seems prepared to take the steps that can stop this inexorable decline. They are all busily telling their electorates that austerity is for other people (France), or that the piddling attempts they have made at it will solve the problem (Britain), or that taxing “the rich” will make it unnecessary for government to cut back its own spending (America).

So here we all are. Like us, the member nations of the European single currency have embarked on their very own double (or is it triple?) dip recession. This is the future: the long, meandering “zig-zag” recovery to which the politicians and heads of central banks allude is just a euphemism for the end of economic life as we have known it.

Now there are some people for whom this will not sound like bad news. Many on the Left will finally have got the economy of their dreams – or, rather, the one they have always believed in. At last, we will be living with that fixed, unchanging pie which must be divided up “fairly” if social justice is to be achieved. Instead of a dynamic, growing pot of wealth and ever-increasing resources, which can enable larger and larger proportions of the population to become prosperous without taking anything away from any other group, there will indeed be an absolute limit on the amount of capital circulating within the society.

The only decisions to be made will involve how that given, unalterable sum is to be shared out – and those judgments will, of course, have to be made by the state since there will be no dynamic economic force outside of government to enter the equation. Wealth distribution will be the principal – virtually the only – significant function of political life. Is this Left-wing heaven?

Well, not quite. The total absence of economic growth would mean that the limitations on that distribution would be so severe as to require draconian legal enforcement: rationing, limits on the amount of currency that can be taken abroad, import restrictions and the kinds of penalties for economic crimes (undercutting, or “black market” selling practices) which have been unknown in the West since the end of the Second World War.

In this dystopian future there would have to be permanent austerity programmes. This would not only mean cutting government spending, which is what “austerity” means now, but the real kind: genuine falls in the standard of living of most working people, caused not just by frozen wages and the collapse in the value of savings (due to repeated bouts of money-printing), but also by the shortages of goods that will result from lack of investment and business expansion, not to mention the absence of cheaper goods from abroad due to import controls.

And it is not just day-to-day life that would be affected by the absence of growth in the economy. In the longer term, we can say good-bye to the technological innovations which have been spurred by competitive entrepreneurial activity, the medical advances funded by investment which an expanding economy can afford, and most poignantly perhaps, the social mobility that is made possible by increasing the reach of prosperity so that it includes ever-growing numbers of people. In short, almost everything we have come to understand as progress. Farewell to all that. But this is not the end of it. When the economy of a country is dead, and its political life is consumed by artificial mechanisms of forced distribution, its wealth does not remain static: it actually contracts and diminishes in value. If capital cannot grow – if there is no possibility of it growing – it becomes worthless in international exchange. This is what happened to the currencies of the Eastern bloc: they became phoney constructs with no value outside their own closed, recycled system.

When Germany was reunified, the Western half, in an act of almost superhuman political goodwill, arbitrarily declared the currency of the Eastern half to be equal in value to that of its own hugely successful one. The exercise nearly bankrupted the country, so great was the disparity between the vital, expanding Deutschemark and the risibly meaningless Ostmark which, like the Soviet ruble, had no economic legitimacy in the outside world.

At least then, there was a thriving West that could rescue the peoples of the East from the endless poverty of economies that were forbidden to grow by ideological edict. It remains to be seen what the consequences will be of the whole of the West, America included, falling into the economic black hole of permanent no-growth. Presumably, it will eventually have to move towards precisely the social and political structures that the East employed. As the fixed pot of national wealth loses ever more value, and resources shrink, the measures to enforce “fair” distribution must become more totalitarian: there will have to be confiscatory taxation on assets and property, collectivisation of the production of goods, and directed labour.

Democratic socialism with its “soft redistribution” and exponential growth of government spending will have paved the way for the hard redistribution of diminished resources under economic dictatorship. You think this sounds fanciful? It is just the logical conclusion of what will seem like enlightened social policy in a zero-growth society where hardship will need to be minimised by rigorously enforced equality. Then what? The rioting we see now in Italy and Greece – countries that had to have their democratic governments surgically removed in order to impose the uniform levels of poverty that are made necessary by dead economies – will spread throughout the West, and have to be contained by hard-fisted governments with or without democratic mandates. Political parties of all complexions talk of “balanced solutions”, which they think will sound more politically palatable than drastic cuts in public spending: tax rises on “the better-off” (the only people in a position to create real wealth) are put on the moral scale alongside “welfare cuts” on the unproductive.

This is not even a recipe for standing still: tax rises prevent growth and job creation, as well as reducing tax revenue. It is a formula for permanent decline in the private sector and endless austerity in the public one. But reduced government spending accompanied by tax cuts (particularly on employment – what the Americans call “payroll taxes”) could stimulate the growth of new wealth and begin a recovery. Most politicians on the Right understand this. They have about five minutes left to make the argument for it.

THE PATHETIC STATE OF THE GLOBAL FINANCIAL SYSTEM WAS AGAIN ON DISPLAY THIS WEEK. Stocks around the world go up when a major central bank pumps money into the financial system. They go down when the flow of money slows and when the intoxicating influence of the latest money injection wears off. Can anybody really take this seriously? On Tuesday, the prospect of another gigantic cash infusion from the ECB’s printing press into Europe’s banking sector, which is in large part terminally ill but institutionally protected from dying, was enough to trigger the established Pavlovian reflexes among portfolio managers and traders.

None of this has anything to do with capitalism properly understood. None of this has anything to do with efficient capital allocation, with channelling savings into productive capital, or with evaluating entrepreneurship and rewarding innovation. This is the make-believe, get-rich-quick (or, increasingly, pretend-you-are-still-rich) world of state-managed fiat-money-socialism. The free market is dead. We just pretend it is still alive.

There are, of course those who are still under the illusion that this can go on forever. Or even that what we need is some shock-and-awe Über-money injection that will finally put an end to all that unhelpful worrying about excessive debt levels and overstretched balance sheets. Let’s print ourselves a merry little recovery.

How did Mr. Bernanke, the United States’ money-printer-in-chief put it in 2002? “Under a paper-money system, a determined government can always generate higher spending…” (Italics mine.)

Well, I think governments and central banks will get even more determined in 2012. And it is going to end in a proper disaster.

Lender of all resorts

Last week in one of their articles on the euro-mess, the Wall Street Journal Europe repeated a widely shared myth about the ECB: “With Germany’s backing, the ECB has so far refused to become a lender of last resort, …” This is, of course, nonsense. Even the laziest of 2011 year-end reviews will show that the ECB is precisely that: A committed funder of states and banks. Like all other central banks, the ECB has one overriding objective: to create a constant flow of new fiat money and thus cheap credit to an overstretched banking sector and an out-of-control welfare state that can no longer be funded by the private sector. That is what the ECB’s role is. The ECB is lender of last resort, first resort, and soon every resort.

Let’s look at the facts. The ECB started 2011 with record low policy rates. In the spring it thought it appropriate to consider an exit strategy. The ECB conducted a number of moderate rate hikes that have by now all been reversed. By the beginning of 2012 the ECB’s policy rates are again where they were at the beginning of 2011, at record low levels.

So why was the springtime attempt at “rate normalization” aborted? Because of deflationary risks? Hardly. Inflation is at 3 percent and thus not only higher than at the start of the year but also above the ECB’s official target.

The reason was simply this: states and banks needed a lender of last resort. The private market had lost confidence in the ability (willingness?) of certain euro-zone governments to ever repay their massive and constantly growing debt load. Certain states were thus cut off from cheap funding. The resulting re-pricing of sovereign bonds hit the banks and made it more challenging for them to finance their excessive balance sheets with money from their usual sources, not least U.S. money market funds.

So, in true lender-of-last resort fashion, the ECB had to conduct a U-turn and put those printing presses into high gear to fund states and banks at more convenient rates. While in a free market, lending rates are the result of the bargaining between lenders and borrowers, in the state-managed fiat money system, politicians and bureaucrats define what constitutes “sustainable” and “appropriate” interest rates for states and banks. The central bank has to deliver.

The ECB has not only helped with lower rates. Its balance sheet has expanded over the year by at least €490 billion, and is thus 24% larger than at the start of the year. This does not even include this week’s cash binge. The ECB is funding ever more European banks and is accepting weaker collateral against its loans. Many of these banks would be bust by now were it not for the constant subsidy of cheap and unlimited ECB credit. If that does not define a lender of last resort, what does?

And as I pointed out recently, the ECB’s self-imposed limit of €20 billion in weekly government bond purchases (an exercise in market manipulation and subsidization of spendthrift governments but shamelessly masked as an operation to allow for smooth transmission of monetary policy) is hardly a severe restriction. It would allow the ECB to expand its balance sheet by another €1 trillion a year. (The ECB is presently keeping its bond purchases well below €20 billion per week.)

Deflation? What deflation?

It is noteworthy that there still seems to be a widespread belief that all this money-printing will not lead to higher inflation because of the offsetting deflationary forces emanating from private bank deleveraging and fiscal austerity.

I STILL THINK THE MOST LIKELY SCENARIO IS THAT SOME AGREEMENT TO AGREE IS MADE AT THE SUMMIT, which is then followed up by increased printing from the ECB, coupled with new Fed policies and fresh IMF money. Although that still seems the most likely, I am getting concerned that Europe is once again missing the point.

Many EU leaders seem to actually believe that the Treaty changes are important. The reality is the market could care less about treaty changes. The market cares about only one thing, that the ECB will announce new, bigger, more aggressive sovereign purchases. That’s all the market cares about. The market believes that the treaty changes provide an excuse for the ECB and IMF to ramp up their efforts. The EU can do all the treaty changes it wants, but if it is not followed up with aggressive new printing policies, the markets will sell-off.

Not only are politicians acting as though the treaty changes mean much, there is even talk about being able to implement changes without national votes. That idea horrifies me on a personal level as it is yet again trashing any sense of democracy, but it is bad for the markets. I have been assuming that the meeting will result in another agreement to agree. That is relatively easy to pull together. Since it doesn’t really mean much, any countries that aren’t really on board, can be cajoled into holding hands for the photo op and pretending they agree long enough for the ECB and IMF to throw more money at the problem.

Agreement is far less likely if real permanent changes are being implemented. It is one thing to agree to the plan on the condition that you have to go back and get approval. It is much more risky for someone to agree to permanent changes implemented using some backdoor legal technique. Talk of actually implementing policy action this week is actually a negative as it makes it less likely that they can announce a “successful” summit.

On a side note, my favorite part of the proposal is the fines for going over the approved limits. So countries that have the biggest deficits will be fined, adding to those deficits? Debtor’s prison never worked very well, so why this would accomplish much is beyond me and would likely be waived any time it could be used. But no one on Wall Street has bothered to read the treaty proposals because no one cares, all anyone cares about is that the ECB uses it as an excuse to print.

Yesterday’s FT rumor of ESM and EFSF working together was yet another reason to be afraid that Europe doesn’t get it. Not only would implementing both at the same time place the AAA rated countries at greater risk of downgrade, it ignores the fact that EFSF has been a total failure. I thought Europe had moved beyond floating yet another iteration of something that hasn’t worked. The fact that they haven’t is a potential indication that the printing presses aren’t going to be turned on as soon as the market would like.

Finally, there is more and more talk about what the national central banks can do. People are acting as though they were cleaning the living room, and found some money when they lifted up the cushions on the couch. This is not “found” money. Participants and lenders are well aware of these reserves. They can be used for example to fund loans to the IMF to lend back to some countries, though I don’t fully understand why they can’t just lend to the countries directly, but I assume there is some law that lending to the IMF lets them circumvent. But there will be a cost to these actions. There will be a consequence, and although it will later be viewed as “unintended” the consequences are actually foreseeable. The countries with large reserves at the national central bank level have a reduced cost of funds because of those reserves. Lenders are not always totally stupid. There is value that is being realized from having those reserves. Using them to create loans for the IMF will impact that country’s ability to borrow. Plain and simple.

The fact that many pundits are treating this as newfound money that can be used any which way, without consequences is absurd and is yet another example of why so many ideas have failed. Any plan that raids the national central banks for money for the PIIGS needs to be thought through more carefully and the potential costs need to be addressed. The cost/benefit analysis may be worth the risk, but I suspect serious analysis would show that it is a bad idea. The cost/benefit should be about zero since it is just shifting money from one place to another. There really is no obvious reason to believe that this is a net positive. In the real world it is likely negative because as we have seen time and again, these changes break the existing model and that causes confusion which more than offsets any potential benefit (not triggering CDS is a shining example).

So while we limp along towards the most likely outcome, the risk of disappointment or even outright failure continues to grow. The inability to hold yesterday’s rumor rally is a signal that the market has moved well past the short squeeze phase and is now trading long.

I CAN’T HELP BUT FEEL THAT WE ARE WATCHING A PERFORMANCE THIS WEEK. It feels like the actions, the meetings, and the statements are all very scripted. It seems reasonably clear which ending they are going for, but many of their actions also fit the “alternative” ending so it remains imperative to be cautious.

Roles for “bit” players have been cut

Last week, for the first time, the EU seemed to be able to muzzle the minor players and even limit the lines of the big players. The Finance minister summit was a failure. Nothing useful came out of it. EFSF was a total flop. The bank backstop plans are at a national level and revolve around the idea of getting banks to borrow even more in the short term and not extend their maturities.

In spite of the obvious failure, there were relatively few comments. Rather than getting headlines of disputes, or even headlines of bigger and better ways to leverage, they seemed to let it die a relatively calm death and move on. This was a chance for every finance minister to get their quotations in the news, but they seemed reasonably constrained. There were far fewer comments about the ECB or even from ECB members. To me, it seems that the big players (Merkozy and Draghi) have taken control of the play and are trying to get it to the ending they want.

The “Script”

Germany took great pains last week to distance themselves from ECB decisions. The speeches made it clear that the ECB should be “independent”. This has been taken as a sign that Germany is relenting on letting the ECB print. By affirming the ECB’s independence, Germany can, in theory, explain that it wasn’t responsible for the printing. There is also a chance that this is a way to take the blame off of Germany if the ECB decides not to print. That seems less likely, but not everyone, especially at the ECB, believes printing is a solution, so this could be a way for them to take the focus off of Germany’s “nein”.

According to the script, Merkel and Sarkozy will become the Merkozy again tonight so that they can ride into this week’s summit with a “renewed joint focus”, blah, blah, blah. There is no way that they don’t act as though they have some agreement (even if they don’t). We won’t know what is discussed, we won’t know how much time is spent working out plans for a summit failure, all we will get is another handholding moment meant to encourage the market. I suspect that more time “off screen” will be spent discussing preparations for a failed summit, but all we will see is smiling confident faces.

At this point, I will give the politicians some credit. For the first time in months they seem to be writing the script. They aren’t just taking whatever script Wall Street hands them, and trying to act that out. The Wall Street scripts haven’t worked and have been unbelievable. The politicians are finally taking control and trying to develop their own plan, and selling Wall Street on how viable it is. Since they are politicians, they are actually trained at figuring out what can get done and selling it to the people. It probably won’t work, but at least they are doing what they are good at, and it would be hard to do worse than listening to another round of self-serving Wall Street advice. On a refreshing note, at least we have agreement on something, Wall Street and politicians now both think the other group doesn’t understand anything and has no sense of timing.

The “puppets” are pushing through austerity in Italy and Greece. They can be held up as shining examples to other countries of what needs to be done. They aren’t the heroes of the story, but are there so that the Merkozy can point them out and show that i) it can be done, and ii) when it is done, the EU and IMF will come through with additional funds. The “it” they got done won’t be well defined (but this is a movie, not the real world anyways) but the reward those good countries receive will be highlighted.

So the meeting will have Merkozy telling the smaller and problematic countries what a great future lies ahead for the eurozone. They will talk about the sacrifices they are making to ensure the viability of the future. There will be no criticism of the plan as only “friends and family” reports will get the inside scoop, and the “trailer” will be played over and over as part of the advertising campaign. We, the audience, will suspect that all the best parts of the play are in the “trailer” but we won’t be able to dig deep enough to argue against it.

The puppets will tell the other countries how happy they are that they have finally adopted austerity with growth to move forward and that they are excited about this opportunity to be part of the renewed commitment to the eurozone. Anyone who tries to figure out how austerity and growth work together, or where the money is coming, or any other details, will be escorted from room, and will be Clockwork Oranged into reading “fringe blogging websites” until they accept that details are bad, and only vague notions and slogans can “solve” anything.

At the end of the day, any holdouts will get invited to special meetings with the Merkozy. This is where they will be asked what they want to get in order to support the agreement, and reminded, that it is only an agreement in principle so they might as well say yes now, and they can always reject it later. These dark little meetings where the bribes are given and the futility of the agreement are discussed will only be available on the director’s cut, but will make people cringe when they realize what went on.

So in the end, according to script, everyone will get a chance for a joint communiqué and photo up where they talk about their commitment to implement these progressive changes. Every person who truly thinks about it for more than a minute, will know that it is a sham. They will see what has gone on, but it won’t matter. The “critics” will fall all over themselves to proclaim the success of the summit and that we are witnessing the birth of a new and better Euro. For a few days at least, the airwaves will be filled with the excitement that the “great leadership” exhibited by the Merkozy, and the diligence of the puppets, has led to such a monumental agreement. The future will be so bright, some might even “wear shades” when they discuss what has been accomplished. Tears wouldn’t even shock me.

Then before anyone can complain that the positive reviews were bought, or that the script is flimsy, we will see the next wave of activity. This will be like a giant publicity machine, trying to turn a horrible movie into an Oscar winner through the sheer strength of publicity and graft.

The ECB will cut rates by 50 bps. The ECB will announce further participation in the secondary markets and hint at the ability and willingness to print money. The IMF will announce some new programs. The EFSF will start participating in the primary market. Even the Fed might hint at future QE (if not actually doing anything).

Then the leaders can sit back and hope their magic works. Hope that their story has been bought and that the markets can take off and that they won’t actually have to implement much. Yes, I think this is the key here. They know that the treaty agreement changes are unlikely to be implemented. They know the ECB has limits, that the IMF is going to struggle to do what people seem to believe they can do, they just hope that this is enough to give the markets so much confidence that they don’t have to do anything. A market that can swing 6% on a 50 bp rate cut, might be manipulated into going so high that confidence is regained, long enough to buy time.

The “alternative ending”

So far, the directors have rejected the alternative ending. They don’t think that America in particular is ready for a non Hollywood ending, but they are filming some scenes just in case. Fortunately many of the scenes are exactly the same as in the preferred ending. In the alternative ending, Merkozy and the puppets can’t convince everyone to go along with the communiqué. They can’t convince them that it is really meaningless so there is no point to disagree. Somehow the summit ends without the decision to move forward.

THE EUROPEAN DEBT BUBBLE HAS BURST, AND THE REPRICING OF RISK AND DEBT CANNOT BE PUT BACK INTO THE BOTTLE. It’s really this simple, Europe: either rebel against the banks or accept decades of debt-serfdom. All the millions of words published about the European debt crisis can be distilled down a handful of simple dynamics. Once we understand those, then the choice between resistance and debt-serfdom is revealed as the only choice: the rest of the “options” are illusory.

The euro enabled a short-lived but extremely attractive fantasy: the more productive northern EU economies could mint profits in two ways: A) sell their goods and services to their less productive southern neighbors in quantity because these neighbors were now able to borrow vast sums of money at low (i.e. near-“German”) rates of interest, and B) loan these consumer nations these vast sums of money with stupendous leverage, i.e. 1 euro in capital supports 26 euros of lending/debt.

The less productive nations also had a very attractive fantasy: that their present level of productivity (that is, the output of goods and services created by their economies) could be leveraged up via low-interest debt to support a much higher level of consumption and malinvestment in things like villas and luxury autos.

Northern Europe has fueled its growth through exports. It has run huge trade imbalances, the most extreme of which with these same Southern European countries now in peril. Productivity rose dramatically compared to the South, but the currency did not.

This explains at least part of the German export and manufacturing miracle of the last 12 years. In 1999, exports were 29% of German gross domestic product. By 2008, they were 47%—an increase vastly larger than in Italy, Spain and Greece, where the ratios increased modestly or even fell. Germany’s net export contribution to GDP (exports minus imports as a share of the economy) rose by nearly a factor of eight. Unlike almost every other high-income country, where manufacturing’s share of the economy fell significantly, in Germany it actually rose as the price of German goods grew more and more attractive compared to those of other countries. In a key sense, Germany’s currency has been to Southern Europe what China’s has been to the U.S.

Flush with profits from exports and loans, Germany and its mercantilist (exporting nations) also ramped up their own borrowing – why not, when growth was so strong?

But the whole set-up was a doomed financial fantasy. The euro seemed to be magic: it enabled importing nations to buy more and borrow more, while also enabling exporting nations to reap immense profits from rising exports and lending.

Put another way: risk and debt were both massively mispriced by the illusion that the endless growth of debt-based consumption could continue forever. The euro was in a sense a scam that served the interests of everyone involved: with risk considered near-zero, interest rates were near-zero, too, and more debt could be leveraged from a small base of productivity and capital.

But now reality has repriced risk and debt, and the clueless leadership of the EU is attempting to put the genie back in the bottle. Alas, the debt loads are too crushing, and the productivity too weak, to support the fantasy of zero risk and low rates of return.

For years, European debt was being mispriced in the (over-liquefied, over-leveraged and over-speculated global) marketplace. Countries such as Greece, Portugal, Ireland, Spain and Italy benefitted immeasurably from the market perception that European monetary integration ensured debt, economic and policymaking stability.

Similar to the U.S. mortgage/Wall Street finance Bubble, the marketplace was for years content to ignore Credit excesses and festering system fragilities, choosing instead to price debt obligations based on the expectation for zero defaults, abundant liquidity, readily available hedging instruments, and a policymaking regime that would ensure market stability.

Importantly, this backdrop created the perfect market environment for financial leveraging and rampant speculation in a global financial backdrop unsurpassed for its capacity for excess. The arbitrage of European bond yields was likely one of history’s most lucrative speculative endeavors. (link via U. Doran)

In simple terms, this is the stark reality: now that debt and risk have been repriced, Europe’s debts are completely, totally unpayable. There is no way to keep adding to the Matterhorn of debt at the old cheap rate of interest, and there is no way to roll over the trillions of euros in debt that are coming due at the old near-zero rates.

CONCLUSION: EUROPE IS IN BAD SHAPE. This is hedge fund manager Kyle Bass’s assessment of the situation in Europe. He stated this in a rousing interview on the BBC’s TV network. Here is the segment:

He made two crucial points – points that stock market investors are ignoring. First, over the last nine years, there has been an increase of world debt from $80 trillion to $210 trillion. These numbers are staggering. Global debt over the last nine years has grown at 12% per year, while GDP has grown at 4% per year.

While he did not verbally spell out the conclusion for the interviewer, it is this: when credit must grow by 12% per year in order to produce 4% GDP growth, at some point there will not be enough GDP to supply sufficient credit. It is time once again to quote economist Herb Stein: “When something cannot go on forever, it has a tendency to stop.”

Bass had a great metaphor: the PIIGS have “sailed into a zone of insolvency.” Second, he explained, the sovereign debts in Europe will be written down. There is no other solution. The airhead interviewer with the Oxbridge accent seemed to be doing a college-skit imitation of Emma Thompson. She challenged him. What about Germany? Can’t Germany continue to fund Europe’s “southern neighbors”? Germany has “the earning power.” (Note: this means German taxpayers.)

Bass responded instantly. First, the German court has determined that any further bailouts are unconstitutional. Second, Greece – and, by implication, the other “southern neighbors” – will spend every euro it borrows from Germany and then come back for more, threatening a default if its demands are not met – exactly what it has done so far. This goes on until the write-down takes place, which it will.

There are two ways of looking at this: the Bass way and the Bass-ackwards way. The airhead chose the latter.

He draws conclusions from the numbers. No one in the mainstream media and mainstream investment fund world seems to be willing to do this. They talk and invest as if the process can go on forever. Debts need not be repaid. This is ancient Keynesian dogma that goes back to the New Deal. “We owe it to ourselves.” On the contrary, specific borrowers owe it to specific creditors. At some point, the specific borrowers are going to default, leaving specific creditors with huge losses. How huge?

THREE TRILLION EUROS!

Charles Hugh Smith agrees with Bass. He says that there will have to be a write-down. By “write-down” he means write-off. He estimates the losses at three trillion euros. Someone will have to take the hit. The great political debate in Europe today is over who will take this hit, and how soon.

It will be investors. But, to forestall the day of reckoning, Europe’s politicians pretend that taxpayers’ credit lines can be used by superficially solvent Northern European governments in order to borrow more money from creditors in order to lend to the PIIGS’s governments, so that the PIIGS’s governments can continue to (1) delay real austerity measures, i.e., massive layoffs of government workers and massive cuts in welfare payments, and (2) make payments on what they owe to investors, mainly banks.

Smith admits that three trillion euros is a guess. Nobody knows how much bad sovereign debt there is, so we must start somewhere. In a world of $210 trillion worth of debt, his estimate seems reasonable to me.

Let’s start with the most basic fact about all this uncollectible, impaired, bad debt: every euro of debt is somebody else’s asset. Wipe out the debt and you wipe out the asset. That’s why there’s no willingness to accept the writedown of debt: somebody somewhere has to suck up 3 trillion euros of loss.

This is the source of Europe’s present policy of “kick the can,” or more accurately, “kick the can with press releases and summits.” If there were a pain-free solution, it would have been implemented long ago. There is no way Europe is going to “grow its way out of this debt.” How much of the eurozone’s “growth” was the result of rampant malinvestment and risky borrowing? More than anyone dares admit. It won’t take austerity to crash the euroland economy, all it will take is turning off the debt spigot.

Europe is facing the problem that Bass raised when he spoke of 12% per year increases of credit and 4% increases per year of GDP. There is no way to grow your way out of this. This is not just Europe’s problem. It is the world’s problem. But Europe is facing it now because the debts are coming due now. They must be rolled over. Creditors must agree to re-lend. But why should they?

The Establishment world of crony capitalism speaks of “re-structuring” the debt. What does this mean? Smith does not pull any punches.

“Restructuring” is a code word for writeoffs. Here, let me “restructure” the euro bond you bought at a 4% coupon yield. Now you’re going to get 2%, and you’re going to like it. Bang, your bond just lost half its market value, but everyone gets to keep it on the books at full value. Nice, until you have to sell it to raise cash. Oops, the euro has slipped in value so you lost more than 50%.

The banks keep the assets on the books at face value. The underlying value is down by at least 50% for Greek bonds. The European experts admit this. (Why the debt is worth that high a percentage is beyond me.) The Greeks are going to default, one way or another.

Who will take the hit? Smith writes: “There’s a fundamental truth that everyone has to understand: what the government spends, the public will pay for sooner or later, whether in taxes or inflation or having their debt defaulted on.” This is reality. But it’s not precise enough.

WHO IS THE PUBLIC?

If there is hyperinflation – price inflation above 30% per year for a decade or more – the public that takes the hit will be almost everyone inside the eurocurrency zone. There will be almost universal hardship.

On the other hand, if monetary inflation ceases for more than a few months, there will be a depression. Big banks will fail. Their depositors will lose everything. The money supply will shrink. It will be 1930-38 all over again.

Central bankers do not allow such things. The European Central Bank will try to walk the tightrope, just as the national central banks in Europe did after World War II. The ECB will pursue boom-bust policies, refusing to capitulate either to a Great Depression or hyperinflation.

But how can it walk this tightrope? The losses will be huge for large banks. The politicians will try to transfer the cost of bailing out Europe’s banks to Germany. But the debts are too large.

OFTEN, WHEN I TROLL AROUND WEBSITES OF ENTITIES LIKE THE ECB AND IMF, I UNCOVER LITTLE OF STARTLING NOTE. They design it that way. Plus, the pace at which the global financial system can leverage bets, eviscerate capital, and cry for bank bailouts financed through austerity measures far exceeds the reporting timeliness of these bodies.

That’s why, on the center of the ECB’s homepage, there’s a series of last week’s rates – and this relic – an interactive Inflation Game (I kid you not) where in 22 different languages you can play the game of what happens when inflation goes up and down. If you’re feeling more adventurous, there’s also a game called Economia, where you can make up unemployment rates, growth rates and interest rates and see what happens.

What you can’t do is see what happens if you bet trillions of dollars against various countries to see how much you can break them, before the ECB, IMF, or Fed (yes, it’ll happen) swoops in to provide “emergency” loans in return for cuts to pension funds, social programs, and national ownership of public assets. You also can’t input real world scenarios, where monetary policy doesn’t mean a thing in the face of tidal waves of derivatives’ flow. You can’t gauge say, what happens if Goldman Sachs bets $20 billion in leveraged credit default swaps against Greece, and offsets them (partially) with JPM Chase which bets $20 billion, and offsets that with Bank of America, and then MF Global (oops) and then…..you see where I’m going with this.

We’re doomed if even their board games don’t come close to mimicking the real situation in Europe, or in the US, yet they supply funds to banks torpedoing local populations with impunity. These central entities also don’t bother to examine (or notice) the intermingled effect of leveraged derivatives and debt transactions per country; which is why no amount of funding from the ECB, or any other body, will be able to stay ahead of the hot money racing in and out of various countries. It’s not about inflation – it’s about the speed, leverage, and daring of capital flow, that has its own power to select winners and losers. It’s not the ‘inherent’ weakness of national economies that a few years ago were doing fine, that’s hurting the euro. It’s the external bets on their success, failure, or economic capitulation running the show. Similarly, the US economy was doing much better before banks starting leveraging the hell out of our subprime market through a series of toxic, fraudulent, assets.

The paper is full of mathematical formulas and statistical jargon, which may be why the media didn’t pick up on it, but hey, I got a couple of degrees in Mathematics and Statistics, so I went all out. And it’s fascinating stuff.

Basically, it shows that between the advent of the euro in 1999, and 2007, spreads between the bonds of peripheral countries and core ones in Europe were pretty stable. In other words, the risk of any country defaulting on its debt was fairly equal, and small. But after the 2007 US subprime asset crisis, and more specifically, the advent of Federal Reserve / Treasury Department construed bailout-economics, all hell broke loose – international capital went AWOL daring default scenarios, targeting them for future bailouts, and when money leaves a country faster than it entered, the country tends to falter economically. The cycle is set.

The US subprime crisis wasn’t so much about people defaulting on loans, but the mega-magnified effects of those defaults on a $14 trillion asset pyramid created by the banks. (Those assets were subsequently sold, and used as collateral for other borrowing and esoteric derivatives combinations, to create a global $140 trillion debt binge.) As I detail in It Takes Pillage, the biggest US banks manufactured more than 75% of those $14 trillion of assets. A significant portion was sold in Europe – to local banks, municipalities, and pension funds – as lovely AAA morsels against which more debt, or leverage, could be incurred. And even thought the assets died, the debts remained.